By Faith Sing and Kelvin Ho
In our previous article, we looked at three key control concepts common across three sets of shareholder arrangements published by three venture capital (VC) associations.
To recap, we looked at the template shareholders arrangements published by:
- the United States based National Venture Capital Association,
- the British Venture Capital Association, and
- the Australian Private Equity & Venture Capital Association.
In this article, we explore what these documents say should happen where a shareholder decides to sell their shares.
Concept 1 – There should be restrictions on transfers of shares (at least for some shareholders)
All three sets of VC association shareholder arrangements include restrictions on at least some shareholders from transferring their shares except in certain situations.
There are at least two reasons for this:
- With an early stage business, execution is key and largely dependent on the team involved. This means that investors are likely to want to ensure that key team members’ economic interests remain fully aligned with the success of the business and they do not sell their shares prematurely.
- In addition, all shareholders are likely to have a view on which of their fellow and potential shareholders they’d prefer to partner with to grow the business. Sometimes, this means there is a focus on transfers of shares by non-key team members too.
Concept 2 – There should be some exceptions to such restrictions
Just as there are good reasons to require a restriction on transfers of shares, there are reasons for exceptions to such a rule.
To start with, there are some obvious exceptions, such as:
- transfers to affiliates where the shareholder is a company in a group of companies. Shares are essentially held within the same group both before and after the transfer;
- transfers for estate or tax planning purposes or otherwise to close relatives. Economic incentives are unlikely to have shifted with such a transfer; or
- creating a mortgage over some shares where the mortgagee agrees to be bound by the shareholder arrangements.
These specific exceptions are not consistent across the three sets of VC association shareholder arrangements. Further, even consolidating all such exceptions may not give enough scope to those wanting to sell their shares.
Concept 3 – Sometimes, the fair outcome is to give both sides some of what they want (the pre-emptive right on transfers of shares)
Ultimately, all shareholders will want to realise their investment. This is likely to occur at different times for different shareholders. A shareholder may need to raise funds as a result of an unplanned exigency, their priorities may evolve over time or they may have always had an investment horizon in mind.
The solution that broadly applies across all three sets of VC association shareholder arrangements is to provide for pre-emptive rights on transfers of shares. It works like this:
- The selling shareholder gets to sell their shares on terms negotiated with a third party; and
- The remaining shareholders get to influence who may become a new shareholder and how many shares the new shareholder holds by exercising their call option to buy these shares on the third party terms.
There are two broad approaches with pre-emptive rights on transfers of shares. It could be a:
- Right of first offer – the selling shareholder must first offer the sale shares to the current shareholders at a price nominated by the selling shareholder. If the seller does not sell such shares at the price it nominates, it can offer them to a third party at or above that price within a period after the offer.
- Right of last offer – the selling shareholder must first obtain an offer from a third party for the sale shares and cannot sell to the third party without offering the shares to the current shareholders at that third party price.
Of course, the devil is in the detail and the three sets of VC association shareholder arrangements are not always consistent in how they deal with such details.
Concept 4 – Sometimes, shareholders may also want to transfer their shares if a shareholder or group of shareholders decides to transfer their shares (the tag-along right)
Shareholders might want to act on their views about a potential change in the share register not by buying more shares (under a pre-emptive right) but by selling their shares (under a tag-along right).
A tag-along right broadly works like this:
- The selling shareholder gets to sell their shares on terms negotiated with a third party but only if they observe the tag-along right; and
- The other shareholders get to sell their shares to the third party on the same terms as the selling shareholder under their tag-along right.
For some shareholders, the tag-along right is more useful than the pre-emptive right because they may not have the necessary funds at the time to buy more shares under their pre-emptive right.
The tag-along right ensures that such shareholders are given an “out” and not left out to dry where there are significant changes afoot such as:
- if the founders decide to sell their stake in the company – this is especially important since a change in the team might effectively change the profile of the investment itself;
- if there is a significant change in the balance of power in the company as a result of the transfer.
Once again, the devil is in the detail. Some tag-along rights make it virtually impossible for a selling shareholder to sell their shares. Others may have such high thresholds that it is unlikely to be of practical relevance.
At times, the tag-along right becomes untethered from its original moorings and negotiations may become a little confused. It is also often a quid pro quo for its homonym – the drag-along right.
Concept 5 – Sometimes, a shareholder may obtain more for their shares if they are able to deliver 100% of the company and may want everyone else to also transfer their shares (the drag-along right)
The final common share transfer concept across the three sets of VC association shareholder arrangements is the drag-along right. This is a right potential sellers of larger blocks of shares are more likely to ask for.
A drag-along right broadly works like this:
- The selling shareholder gets to sell their shares on terms negotiated with a third party usually on condition that the third party is able to purchase 100% of the company; and
- The selling shareholder also has a call option to require that all other shareholders sell their shares to the third party at the same price, if not the same terms.
This allows a selling shareholder to deliver 100% of the company to the third party buyer and may be critical if a selling shareholder is to unlock an additional “control” premium in its sale price.
While there are likely to be statutory provisions in the relevant jurisdiction providing for compulsory acquisition of shares, these are usually limited in scope and come with potentially onerous conditions.
As with the pre-emptive right on transfers of shares and the tag-along right, details matter. In particular, the drag-along right involves forcing potentially reluctant shareholders to sell their shares. This can get tricky to enforce and requires careful drafting.
Of course, shareholder arrangements may deal with other situations involving a transfer of shares, such as where:
- this is a mechanistic part of a broader requirement that the company or shareholders work towards an “exit” for shareholders such as through a trade sale or an initial public offering;
- this is one remedy for breach of the shareholders’ agreement, for example, so that a breaching shareholder may be efficiently dislodged from the company;
- this is a remedy where there is deadlock and the business is unable to move forward without one or more shareholders leaving the company;
- this is a deterrent to bad behaviour by key executives or a salve where bad behaviour occurs.
In this article, we’ve only dealt with situations where there is a voluntary decision by a shareholder to sell their shares. Watch out for more in the coming months.
Read more on our analysis of the NVCA, BVCA and AVCAL model documents including on:
- similarities in board and shareholder control provisions – 3 key control concepts for a SHA
- different options for board control provisions – 5 key options for board provisions in a SHA
- different options for pre-emptives on transfers – 5 key options for pre-emptives on transfers in a SHA
- different options for drag-along provisions – 5 key options for drag-along provisions in a SHA
- different options for reserved matters – 5 key considerations for a reserved matters list in a shareholders’ agreement
You may also be interested in our thoughts on:
- Singapore model documents – VC model documents for Singapore
- choosing a template agreement – 6 tips for picking a template agreement
Get in touch to explore how we may help you with your shareholder arrangements.
fsLAW is a boutique business law firm group providing legal solutions and advocacy for clients in the Asia Pacific region from Singapore. We provide our services through retainers as well as in the traditional way of an hourly or daily rate or fixed-quote for projects. We provide both Singapore law advice as well as advice on the laws of NSW, Australia, through our two law firms.
This article is provided for general information purposes only and does not constitute legal or other professional advice. Legal services are only provided to clients under an engagement letter. Other communications do not give rise to a solicitor-client relationship or constitute the provision of legal services.